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With Bailout in Question, Cyprus Teeters on Financial Ruin

Facing a Monday deadline before the European Central Bank cuts off funding, Cyprus is racing to prepare a resolution of Laiki Bank, the tiny island country’s second largest bank.

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Laiki Bank, also known as Cyprus Popular Bank, reportedly lowered the daily per-person limit on ATM withdrawals to 260 euros on Thursday amid reports of long lines of jittery customers and clashes with bank employees.

“Clearly, the risk of an exit from the euro zone…has increased,” Marc Chandler, global head of currency strategy at Brown Brothers Harriman, wrote in a note to clients.

Underscoring the concern over the Cypriot banking sector, Standard & Poor's downgraded the country's credit rating by one notch to "CCC" Thursday afternoon, citing the need for 10 billion euros in capital injections for commercial lenders.

S&P said its baseline scenario calls for Cyprus to remain in the eurozone, but warned the "risks of a sovereign default are rising."

"The economy will collapse and unemployment will soar. The social fabric will be torn asunder."

- Marc Chandler of Brown Brothers Harriman

Cyprus has announced its banks will remain closed until Tuesday.

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The scramble comes after the Cypriot parliament overwhelmingly rejected a controversial bailout plan earlier this week that would have raised 5.8 billion euros by imposing a levy on bank deposits, leaving the rescue in doubt.

The Eurogroup said in a statement Thursday afternoon that it "stands ready" to discuss a new Cyprus proposal, which it expects "as rapidly as possible." The group said any new plan should respect the "parameters defined earlier," likely alluding to the previous requirement that Cyprus raise 5.8 billion euros through its incredibly outsized banking system.

Eurozone members "continue to stand ready to assist the Cypriot people in their reform efforts and stand ready to ensure the stability of the euro area as a whole," the statement said.

On the reform front, Cyprus is planning to split Laiki’s assets into good and bad units and then merge the good assets with the country’s largest lender, the Bank of Cyprus, The Wall Street Journal reported.

The Central Bank of Cyprus announced a resolution process Thursday afternoon that would avert bankruptcy and protect depositors with up to 100,000 euros, Reuters reported. The measures will be imposed on Laiki and failure to do will render the bank bankrupt, the central bank governor was quoted was saying.

Earlier, the ECB said it will pull the plug on its Emergency Lending Assistance program to the Central Bank of Cyprus if the country doesn’t reach a deal by Monday.

If the ECB pulls its support, analysts have said the Cypriot banking system is likely to collapse, dragging down the country’s $18 billion economy.

“We think Cypriots' lives will be made significantly worse on an exit,” Chandler said. “The banking system will collapse and the means to recapitalizing it are not obvious. The economy will collapse and unemployment will soar. The social fabric will be torn asunder.”

Jan Randolph, director of sovereign risk at IHS Global Insight, warned that if the banks collapse the Cypriot gross domestic product could plummet 6% to 7% and the country’s unemployment rate may spike above 20%.

While the damage to Cyprus may be great, a collapse of the country’s banking system isn’t seen as a serious threat to the U.S. or even to the eurozone.

Ben Bernanke, the chairman of the Federal Reserve, told reporters on Wednesday that he doesn’t see Cyprus as having “direct implications” or a “major risk” to the U.S. financial system or the U.S. economy.